Problems with Monetary Policy and Fiscal policy

Problems with Monetary Policy and Fiscal policy

Problems with Monetary Policy and Fiscal policy

Monetary policy and fiscal policy under a system of fixed output

Initially, monetary policy and fiscal policy were introduced in an
economy where changes in these policies would affect output. In reality, there
is no real link between monetary policy and real variables. That is,
changes in monetary policy and fiscal policy cannot affect the total level of
output because the total level of output is determined by the factors of
production and not by monetary variables. This is called the neutrality of
money.

What really happens, then, when the Fed and the government use monetary
policy and fiscal policy? If we recall the equation for output of Y = C(Y - T)
+ I + G + NX we can begin this analysis. Given that Y is fixed by the factors
of production, a change in G or T--that is, fiscal policy--must result in a
change in another variable to maintain a constant Y. This change in Y works
directly though the interest rate.

Each of the variables in the output equation is tied to the interest rate.
Consumption tends to fall as the interest rate rises because the incentive
for saving increases. Investment tends to fall as the interest rate rises
because the cost of borrowing money increases. Government spending is not
really affected by the interest rate. Net exports tend to rise as interest
rates rise because domestic investment is relatively more attractive to both
domestic and foreign investors.

When monetary policy and fiscal policy are used the interest rate is affected.
Expansionary monetary policy directly lowers the interest rate by making
money easier and cheaper to obtain. Contractionary monetary policy directly
raises the interest rate by making money harder and more expensive to obtain.
Expansionary fiscal policy increases the interest rate by decreasing the
savings rate through lower taxes and higher government spending.
Contractionary fiscal policy decreases the interest rate by increasing the
savings rate through higher taxes and lower government spending. Thus,
monetary policy and fiscal policy both directly affect consumption, investment,
and net exports through the interest rate.

For example, say the Fed uses expansionary monetary policy such as purchasing
government bonds, decreasing the reserve requirement, or decreasing
the federal funds interest rate. This causes the interest rate to
fall, which
then causes consumption to rise and investment to rise. But, in order for the
total level of output to remain fixed, net exports must fall the same amount
that consumption and investment rise. In this way, total output does not change
from monetary policy, but the division of total output is affected.

Another example is needed. Say the Fed uses contractionary monetary policy such
as selling government bonds, increasing the reserve requirement, or increasing
the federal funds rate. This causes the interest rate to rise which causes
consumption to fall and investment to fall. But, in order for the total level
of output to remain fixed, net exports must rise by the same amount that
consumption and investment fall. In this way, total output does not change from
monetary policy, but the division of total output is affected.